This invention relates to a method and apparatus for investment of funds. More particularly, this invention relates to a method and apparatus which will benefit from investing in financial instruments whose value is expected to decrease relative to the overall market as well as those whose value is expected to increase relative to the overall market.
A wide variety of investment strategies are known to those in the field. Pure long strategies aim to invest in stocks, bonds, or other financial instruments whose value is expected to appreciate. One method is to invest in a pool of stocks which simulate an index such as the Standard and Poor""s 500 Stock Index or the Dow Jones Industrial Average. Another method is to invest in individual or multiple equities whose value is expected to appreciate faster than the indices. A variety of techniques are used to select these equities ranging from analysis of the chart patterns of price and volume history for the equity to fundamental analysis and projections of the underlying business of the company represented by the equity. These methods are referred to as being long or taking long positions. Another method of investing seeks to benefit from financial instruments whose value is expected to decrease. In this method, said instruments are borrowed and sold, in the expectation that the borrowed instrument can be purchased and returned in the future at some lower price. This technique is referred to as selling short or taking short positions. This short selling technique is also commonly used by hedge funds. Short selling generates a cash position and the investor can earn an interest return on this cash.
When the value of the financial instruments that are held is greater than the amount of capital being invested, the position is described as leveraged. The use of leverage is common for long, short, or combined investment strategies. The amount of leverage available is often limited by regulation so as to limit risks. Regulatory changes in 1996 and 1998 have allowed investors to utilize higher leverage amounts. The amount of leverage can be expressed as the ratio of the value of total long plus short investments to the capital invested, expressed as a percent. Thus, if $100 is invested to purchase $100 worth of financial instruments and to sell short $100 worth of financial instruments, the leverage is 200%. The portfolio will be described as 100% long and 100% short. If the investment manager is successful at choosing better performing longs and/or shorts, then the use of leverage will multiply the benefits to the investor.
Many professional managers or management companies invest in baskets of financial instruments, for example stocks, and sell interests in these investment pools to the public. The most common examples are called mutual funds. They mainly use long strategies. Mutual fund investments often produce undesired taxable income for their investors. Even if an investor in a mutual fund or similar entity does not want to sell but rather hold the fund for long term growth, taxable income for that investor will often be generated because the fund chooses to sell some of its holdings for gains. Such sales may also be necessary to generate cash if a party decides to redeem from the fund. The investor will then have to pay income tax and reduce the amount of capital available for investment. Mutual funds which have low turnover, meaning infrequent changes in their portfolios, reduce this problem. Many of these are index funds such as the Vanguard S and P 500 Index Fund. A few funds, for example Vanguard Tax-Managed Balanced Fund, go even further to avoid the generation of taxable income. When positions are sold for gains, they also attempt to offset the gains by selling some of the positions in which they have losses. These tax minimization strategies do, however, limit the flexibility of the funds to change their holdings to take advantage of new circumstances. These funds do not use leverage or strategies which combine long and short positions. Nor do they attempt to isolate short term losses which might be useful to the investor to offset capital gains he may have in other holdings.
Some investment strategies combine both long and short positions. This allows the investment manager to take advantage both of opportunities which are undervalued versus the overall market and opportunities which are overvalued. Such portfolios are discussed in the article by Jacobs and Levy in the Financial Analysts Journal, September/October 1996. A common type of long-short portfolio is a market neutral portfolio. This approach is further discussed in chapter 10 of a book by T. Daniel Coggin and Frank J. Fabozzi entitled Applied Equity Valuation, published by Frank J. Fabozzi Associates, New Hope, Pa., 1998, and in a book edited by Jess Lederman and Robert A. Klein, entitled Market Neutral, published in 1996 by Irwin Professional Publishing, Chicago, Ill., especially chapters 1 and 5. The return on a market neutral fund can depend only on the skill of the person who selects the securities or other financial instruments. Positive returns can be achieved independently of moves in the overall market. If the overall market moves up, positive performance can be achieved if the longs perform better and/or the shorts perform worse than the overall market. If the overall market drops, positive performance can again be obtained if the longs perform better and/or the shorts perform worse than the overall market. Several market neutral mutual funds are available to the public. These are discussed in a Wall Street Journal article of May 13, 1998 and information is also available in fund prospectuses. These funds seek to capitalize on long and short stock picking judgments to yield higher returns than conservative fixed income instruments while maintaining low risk. They do not use leverage to multiply the value of the judgments and do not attempt to manage the tax consequences to the investor.
Market neutral investments are also available as private placements to qualified investors. The prospectuses for such investments are not public documents since they are offered only for purposes of evaluating the investment. Both public and private market neutral funds are discussed in volume 2 of the Journal of Hedge Fund Research, Fall 1995, pages 1-18. Many market neutral investments seek to get better returns than low risk investments such as treasury bills without incurring high risks of losses that might be present in other investment instruments. The article mentions the use of leverage as high as 400%. Other market neutral approaches target higher returns by accepting higher risks. These can also be leveraged. However, these investment approaches focus on the security selection and are relatively insensitive to the tax consequences. This is a disadvantage to the tax paying investor who may have to reduce his total capital under investment in order to pay the taxes incurred. Funds which are structured as limited partnerships or other pass through entities can avoid some of the problems of taxable income by distributing securities instead of cash to investors who choose to redeem. However, they will still cause taxable income to the investors when they sell assets which have increased in value or cover shorts which have decreased in value. The taxable income will frequently occur as short term capital gains. Under current tax laws in the United States, these occur when an investment is held for less than 12 months before it is sold. If the investments are held for 12 months or more before sale they will generate long term capital gains and these will be taxed, albeit at a lower tax rate according to current United States tax law. The gain or loss on a covered short is treated as short-term no matter how long the position has been held.
The particular instruments to be purchased or sold short may be selected by a variety of techniques for predicting expected returns. One family of techniques relates to the analysis of charts of the historical stock movements and their volume. Certain patterns on such charts are believed to be predictive of future stock movements. These techniques are sometimes referred to as technical analysis or charting techniques. One such method is called the Dow theory. Another family of techniques relates to fundamental analysis of the enterprise issuing the financial instrument. The business is modeled and future earnings and dividends are projected. Using a discount rate, the dividends stream and terminal value of the enterprise are converted to a present value and compared to the market price. Other techniques reflect the value of stocks compared to peers using factors such as earnings and dividend growth, dividends, price to earnings ratio, price to book ratio, etc. Other techniques fall in the category of momentum analysis, selecting the financial instruments which seem to be moving most favorably. Other factors such as insider trading patterns can also be utilized. The above and other factors are often combined into mathematical or computer models which can be used to predict the best and worst performing financial instruments. Such modeling methods are referred to as quantitative methods and are described in Chapters 5 of the Lederman/Klein book and 10 of the Coggin and Fabozzi book and in the aforementioned article in the Journal of Hedge Fund Research. In current practice, these investment techniques to evaluate and rank individual securities may be highly quantitative and dependent on computer modeling or they may be more judgmental and qualitative.
The expected return data on individual financial instruments are combined with risk related data such as volatility of the instrument and the expected correlation of returns among the instruments The interaction of these factors allows the development of an array of portfolios with different risk vs. return characteristics. Each portfolio consists of a group of financial instruments. Volatility is an important factor in the calculation of the riskiness of an individual financial vehicle. It may be described by a beta number for the stock which is the ratio of the historical price change (as percent) of the stock compared to the historical price change (as percent) of the overall market. It may also be described statistically as the standard deviation of the price of the stock. Portfolio risk can be reduced or eliminated by balancing the longs and shorts for factors such as industry, size, location, currency sensitivity, and labor sensitivity. A common group of such factors is called the Barra risk factors. The calculation of risk profile is known to those in the art and is described for example in Chapter 10 of the text by Coggin and Fabozzi and in the above mentioned article from the Journal of Hedge Fund Research. Once expected returns are known and risk data are collected, these can be combined in an optimization process by a variety of methods. Such optimization services can be purchased from a variety of suppliers, including BARRA, Berkeley, Calif., Advanced Portfolio Technologies (APT), New York, N.Y., Northfield Information Systems, Inc., Boston, Mass., and Vestek Systems, Inc., San Francisco, Calif. These services will generate arrays of portfolios having different predicted returns and different levels of risk. These portfolios reflect the stock ranking process which is intended to produce an excess return compared to the benchmark (such as a market index). Such an excess return is called an xe2x80x9calphaxe2x80x9d, which is a quantification of the ability of the stock picker to pick longs which do better than the market and/or shorts which do worse than the market. When used in a market neutral portfolio, they are sometimes referred to as double alpha strategies since the alpha is available on both the long and short side. For portfolios which are not balanced on the long and short side, some alpha is still available on each side.
As discussed above, none of the known investment methods combine the benefits of (1) capitalizing on evaluations of short positions as well as longs (2) deferring the need for the investor to reduce capital by paying taxes (3) exploiting the opportunity to aggressively harvest short term losses for the investors and (4) using high leverage to multiply the benefits of the first three items. Harvesting short term losses can produce a benefit to investors who may be able to use them to offset capital gains from other parts of their portfolios. The use of leverage can increase the amount of short term loss that can be harvested from a given level of capital investment.
It is an object of the present invention to provide a method and apparatus for investing which capitalizes on the investment manager""s skill for identifying short selling opportunities as well as opportunities of investing in long positions, multiplies the benefits by using leverage, and handles the purchase and sale of the financial instruments in such a way as to defer the need for the investor to pay taxes on capital gains and to aggressively harvest the realization of capital losses which may be utilized to offset any realized gains from this portfolio or from the investor""s other holdings.
It is also an object of the present invention to provide a method and apparatus for investing which allows the investment manager to exercise judgment to choose the bias of the portfolio toward a short position, a long position, or a market neutral position, while also using leverage to multiply the results of his judgment and handling the purchase and sale of the financial instruments in such a way as to defer the need for the investor to pay taxes on capital gains and to aggressively harvest losses.
It is a further object of the present invention to provide a data processing apparatus which analyzes and optimizes risks and rewards of portfolios, keeps track of the portfolios, analyzes and optimizes the tax consequences, highlights opportunities for trades, maintains records for investors, and analyzes the preferred way to handle any investors who redeem.
The above and other objects of the present invention are realized by constructing a portfolio of short stocks or other financial instruments which are expected to underperform a market and long stocks or other financial instruments which are expected to outperform a market. Leverage of at least 200% would be used to multiply the expected returns. Such an investment approach is expected to produce a mixture of gains and losses in the portfolio. Investment losses would preferentially be realized as short term losses and positions in which there is a gain would preferentially be kept indefinitely as investments. Structure of the investment vehicle as a pass-through entity can generate some additional benefits by avoiding the need to realize gains even when investors redeem their investment.
It is to be understood that both the foregoing general description and the following detailed description are exemplary and explanatory and are intended to provide further explanation of the invention as claimed.